Inflation is here - could bitcoin be the solution?

By JP Patheja Hellmich - July 08, 2021

Inflation is here - and it is higher than anticipated. Bitcoin offers a new means of hedging against inflation with many advantages: it is the first digital object of true scarcity capped at 21 million and it is deflationary in nature; implying its value will increase over time. Since bitcoin is also decentralized, it is not only a hedge against inflation, but also against social and political turmoil. Ultimately, institutional investors as well as retail investors are increasingly exploring alternative hedges and are considering bitcoin, should you?

What is inflation?

Do you remember being a kid and getting a scoop of ice-cream while your parents, and especially grandparents, complained about how expensive a scoop has become? Do you ever think of those moments while you are paying close to 2 Euros for a good scoop today? For that, we have inflation to thank. Inflation essentially is the decline of purchasing power of a currency over time1. In other words - and in economic lingo - it is said to be the increase of the average price level of a certain selected basket of goods. 

The ‘basket of goods’ is encompassed in the Consumer Price Index (CPI)2, which in turn, is used to reflect and quantify inflation - as well as deflation. The CPI is calculated by taking the price changes of each item in the ‘basket’, which although not always specifically defined, include: basic food items such as milk, coffee and cereal; the cost of living implying rent, furniture and utilities; but also other things like haircuts, education, recreational items as well as healthcare costs3, and averaging the increases. The CPI value is often used analogously as the inflationary value. 

There is no consensus about the exact singular cause for inflation (nor whether there is merely a singular cause), however, generally money is devalued through increased money supply; or shocks to the supply of - and demand for - goods, are cited. Ordinarily, an inflation rate of around 2% is considered to be healthy4. For example, according to the Maastricht treaty, the European Central Bank restricts inflation of a member state to 1.5 percentage points higher than the three best performing member states5. Any lower, and deflation is dangerously close which is detrimental to the economy as the value of debt increases and consumers decrease spending as they expect money to appreciate and prices of goods to drop. Higher inflation rates, on the other hand, can lead to hyperinflation. 

Hyperinflation is an extreme form of inflation where prices rise uncontrollably. Generally the term is used when inflation is 50% a month or higher6. This devalues the currency at a rapid rate and physical goods - especially food - become hot commodities. The demand is so high that the prices rise further. This vicious cycle culminates in a complete economic collapse.

One extreme example of hyperinflation happened in Zimbabwe. After obtaining independence, a land redistribution act was passed in which land belonging to white farmers was redistributed to new black farmers in the 1990’s. Many of the new farmers lacked experience, which adversely impacted crop yields and led to nationwide food shortages; a general decline in productive output as well as a collapse of the bank lending system. Simultaneously, the government was fighting a war in Congo for which they started printing money. Debt was piling up and the government decided to print even more in an attempt to bail themselves out7. Ultimately, the Zimbabwean Dollar (ZW$) which was initially valued at USD 1.25 per ZW$ 1 started spiraling. The inflation rate was 16% in 1996; 55% in 2000; 199% in 2002, and peaked at a staggering 79.6 billion %! They even had a one hundred trillion dollar note that was worth only approximately USD 33 in 20098

Figure 2: Zimbabwe’s one hundred trillion dollar note9 

Zimbabwe is only one example of hyperinflation: Hungary in 1945 had a daily (!) inflation rate of 207%; Yugoslavia in 1994 a daily inflation rate of 63%; Germany a daily inflation rate of 21% in 1923 and so on10. Although the countries and time periods greatly differ, there is a common theme of a reduction of production output and simultaneously money being pumped into the system. 

Current state

In expectation of an economic downturn caused by Covid-19, nations have started printing money again in an attempt to cushion the economic blow. For instance, the US unemployment rate prior to Covid-19 hovered around 3.5% (February 2020) and rose to a highest recorded ever of 14.8% with a mere labor force participation rate of 60.2% by April of that same year11. Although it has come down to slightly over 6%, which is still double of the covid-prior levels, relief bills passed till date exceed $5.3 trillion USD12. This is more than six times the amount seen in the American Recovery and Reinvestment Act 2009, to combat the great recession after 2008 ($831 billion USD). 

Figure 3: M2 money stock chart13 

The Federal Reserve measures the total quantity of money in circulation as M2 which is depicted in the graph above. For one, we can see a steadily increasing supply of money but more importantly the drastic jump in 2020 from around $15 trillion USD to over $20 trillion in 2021. Over 25% of the total supply of USD in circulation has been printed since Covid alone. 

This has consequences. The recently released CPI data shows an inflation rate of 5%, which is higher than expected. For contrast, the average inflation rate of the last ten years in the EU has been around 1.9% and the US is only slightly higher14. Taking a closer look at certain goods we can already see the implications of worldwide shortages and inflation, especially in the raw materials sector. Mineral oil prices increased by 47%, ores and metals by 41% and wood by 38%15. According to the UN Food Price Index (FFPI), food prices have risen by almost 40% since 2020 and 5% alone in may 202116

It’s clear, Covid has caused a major shock to our society. Unemployment levels have risen and again large amounts of money are being pumped into the economy. Sound familiar? The exact underlying causes for (hyper) inflation are happening right before our eyes and we are seeing the effects: rising food prices and devaluation of our money. New ways to protect our money are therefore in high demand. 

Traditional means of hedging 

The first thing that comes to mind as a hedge against inflation is gold. Gold holds a long track record as being a store of value and even has been used as currency in the past. It holds intrinsic value as supply is limited17. It is not without its drawbacks though. Since it is a physical asset, it is vulnerable to theft and loss as well as short-term volatility. 

Figure 4: Gold as a hedge against inflation18

Another way of purchasing gold is through commodities trading. Commodities are a very broad category ranging from precious metals, electricity and currencies to oil and food19. Commodities can be invested in through ETFs. The downside of commodities trading is that the price is largely determined through supply and demand, which makes them very volatile and unpredictable, especially in instances of geopolitical tension or conflict.

Instead, perhaps a diversified stock portfolio is the answer. The theory is quite simple, as prices increase, so do the revenues of the companies and hence, the stock price. Long-term the average stock market growth has also outperformed the average rate of inflation. However, there is evidence that while equities in general may outperform inflation on average, they only do so when inflation is somewhat consistent. As soon as inflation becomes volatile, equity value too becomes unstable20.

Bitcoin as a hedge

This is by no means an exhaustive enumeration of inflationary hedges but rather an overview of the most commonly considered. A lesser considered option, with increasing traction, is bitcoin. 

Bitcoin is a digital currency that can not be copied, duplicated or forged and inherently is the first digital object of true scarcity. Miners are rewarded for creating these blocks at a decreasing rate of 50% roughly every four years - or every 210,000 blocks to be precise. This is known as halving. Initially the reward for mining a block was 50 BTC but due to the halving is now down to 6.25 BTC, as of February 202121

The total supply of bitcoin is 21 million22. Once all are mined by the year 2140 no further bitcoins will enter the supply. Then, since no more can be ‘printed’, it will start to become increasingly more valuable. On top of that, a significant number of private keys have been lost and continue to be lost. Bitcoins are thereby taken away from the total supply, which further increases the value. Currently, the estimate is that we are losing 0.5% of total bitcoin supply annually (which is a lot!). Consequently  a deflationary period is expected to begin by 2036, when the rate of lost bitcoins surpasses the rate of newly mined bitcoins23

Another great thing about bitcoin is that it is infinitely divisible meaning we can continue trading with satoshi’s - also referred to as sats if you are in the game. One bitcoin is equal to 100 million sats. This means no matter how valuable one bitcoin may become, there will always be a plausible way to utilize it.

Further, the stock-to-flow (S2F) model, developed by PlanB, is often cited to show that bitcoin is a suitable hedge against inflation. S2F is seen as the most accurate price prediction model for bitcoin, till date24. Essentially, the current supply (stock) is divided by the annual production (flow). The higher the S2F, the higher the price. Gold hovers around an S2F of 63; silver at 22; bitcoin in 2010 at 25 and today closer to 60. Since bitcoin production (flow) is halved every 210,000 blocks, this increases the overall S2F. 

Figure 5: S2F model by PlanB25

Lastly, due to its decentralized nature, bitcoin is not only seen as a hedge against inflation but also against social turmoil and political instability. No government, no matter how powerful, can stop Bitcoin. The Bitcoin network will continue to run securely even if all mining operations in a country are shut down. Furthermore, unlike in the fiat system, no bitcoin “accounts” can be frozen. As long as bitcoin owners custody their own keys, it is much harder, if not impossible, for governments to seize their wealth.

Conclusion 

Ultimately, bitcoin has become an increasingly valuable finite digital currency, free of centralized governing entities and designed to be inevitably deflating. Given inflation is already higher than expected, this explains why more and more retail as well as institutional investors are desperately seeking hedges against inflation. Traditional means such as gold, commodities or a stock portfolio persist. Bitcoin, the new kid on the block, is also highly desired and a suitable hedge against inflation due to its decentralized nature, limited supply and deflationary tendency. 

It is abundantly clear that this disruptive technology is here to stay. It is also clear that traditional approaches may no longer be sufficient to hedge against inflation. But even in the case of the financially literate, navigating the unfamiliar terrain and grasping the concepts that underlie this technology are complex. This is where we at 21Treasury are here to help you. Get in touch with us and we will be happy to tell you more!

References

  1. https://www.investopedia.com/terms/i/inflation.asp
  2. https://www.investopedia.com/terms/c/consumerpriceindex.asp
  3. https://www.investopedia.com/terms/b/basket_of_goods.asp
  4. https://www.economicshelp.org/blog/2114/inflation/optimal-inflation-rate/
  5. https://www.insee.fr/en/metadonnees/definition/c1348
  6. https://corporatefinanceinstitute.com/resources/knowledge/economics/hyperinflation/
  7. https://www.economicshelp.org/blog/390/inflation/hyper-inflation-in-zimbabwe/
  8. https://www.theguardian.com/world/2009/jan/16/zimbabwe-hyper-inflation-mugabe-tsvangirai
  9. https://en.wikipedia.org/wiki/Zimbabwean_dollar#/media/File:Zimbabwe_$100_trillion_2009_Obverse.jpg
  10. https://www.businessinsider.com/worst-hyperinflation-episodes-in-history-2013-9?r=DE&IR=T#weimar-germany-august-1922-december-1923-4
  11. https://fas.org/sgp/crs/misc/R46554.pdf
  12. https://www.pgpf.org/blog/2021/03/heres-everything-congress-has-done-to-respond-to-the-coronavirus-so-far
  13. https://fred.stlouisfed.org/series/M2SL
  14. https://tradingeconomics.com/euro-area/inflation-cpi#:~:text=Inflation%20Rate%20in%20the%20Euro%20Area%20averaged%201.91%20percent%20from,percent%20in%20July%20of%202009.
  15. https://www.spiegel.de/wirtschaft/service/inflation-preise-im-grosshandel-steigen-so-stark-wie-seit-13-jahren-nicht-mehr-a-90a865e7-b7cd-4d85-92ee-91b0513a2af4
  16. http://www.fao.org/worldfoodsituation/foodpricesindex/en/
  17. https://economictimes.indiatimes.com/markets/commodities/views/is-gold-losing-its-lustre-as-a-hedge-asset/articleshow/82388617.cms?from=mdr
  18. https://pixabay.com/photos/gold-is-money-gold-bar-shop-gold-2430052/
  19. https://www.investopedia.com/articles/investing/081315/9-top-assets-protection-against-inflation.asp
  20. https://www.marketwatch.com/story/dont-count-on-stocks-as-an-inflation-hedge-2012-03-09
  21. https://www.investopedia.com/tech/what-happens-bitcoin-after-21-million-mined/#:~:text=When%20bitcoin%20first%20launched%2C%20the,February%2024%2C%202021%2C%20value.
  22. https://stats.buybitcoinworldwide.com/stock-to-flow/
  23. https://blog.trezor.io/bitcoin-has-no-problem-with-deflation-fiat-does-395468654820
  24. https://www.forbes.com/sites/stevenehrlich/2021/04/29/demystifying-bitcoins-remarkably-accurate-price-prediction-model-stock-to-flow/?sh=28ed954f476a
  25. https://specials-images.forbesimg.com/imageserve/608a09fbe9d77bad4722fe56/0x0.jpg?fit=scale

 

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21Treasury offers comprehensive services for interested companies and investors to explore bitcoin, other digital assets, and even Blockchain and other Distributed Ledger Technologies (DLT). In times of increasing inflation due to quantitative easing and low or negative interest rates, companies are steadily realizing the need to rethink their treasury strategies in order to prevent their capital from debasing. Bitcoin and other digital assets have seen a massive influx of corporate and institutional capital which has been partly due to their store of value features. Thus, more and more companies are considering following this approach. Subsequently, this raises the need to understand this new digital asset class.

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